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The Simplest Test of Target Zone Credibility

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  • Svensson, Lars E O

Abstract

Under the assumption of no arbitrage, exchange rate target-zone credibility is tested by whether domestic interest rates fall within `rate-of-return bands' between the maximum and minimum home-currency rate of return on a foreign investment in the absence of a devaluation. Under the assumption of uncovered interest rate parity, credibility is tested by whether expected future exchange rates fall within the exchange rate band. Under the assumption that devaluations are a Poisson process, the expected exchange rate, the probability intensity and the expected size of a devaluation can be related. These tests are illustrated using data on the Swedish target zone between January 1987 and August 1990.

Suggested Citation

  • Svensson, Lars E O, 1991. "The Simplest Test of Target Zone Credibility," CEPR Discussion Papers 493, C.E.P.R. Discussion Papers.
    • Handle: RePEc:cpr:ceprdp:493
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    References listed on IDEAS

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    1. Svensson, Lars E. O., 1991. "The term structure of interest rate differentials in a target zone : Theory and Swedish data," Journal of Monetary Economics, Elsevier, vol. 28(1), pages 87-116, August.
    2. Svensson, Lars E. O., 1992. "The foreign exchange risk premium in a target zone with devaluation risk," Journal of International Economics, Elsevier, vol. 33(1-2), pages 21-40, August.
    3. Paul R. Krugman, 1988. "Target Zones and Exchange Rate Dynamics," NBER Working Papers 2481, National Bureau of Economic Research, Inc.
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    More about this item

    Keywords

    Credibility; Devaluation Risk; Exchange Rates; Interest Rate Bands; Target Zones; Term Structure;
    All these keywords.

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F33 - International Economics - - International Finance - - - International Monetary Arrangements and Institutions

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